Researchers from Queen Mary University of London have developed a new indicator, based on stock index options prices, which can be used to predict future economic growth.
A new study co-authored by Renato Faccini and George Skiadopoulos from Queen Mary’s School of Economics and Finance has resulted in the development of a new indicator for predicting financial growth, Implied Relative Risk Aversion (IRRA).
The IRRA indicator is based on stock index option prices. An option is a contract that gives the buyer the right to buy or sell an underlying security at a specified price on a specified date.
The options market shows the degree to which investors are averse to risk and tend to attract more sophisticated investors than other markets.
The researchers found that index option prices were more informative about the future state of the economy since they reflect the expectations of informed investors first before other markets’ prices do.
The study shows that IRRA can be factored into an economic forecast. It found that contrary to earlier predictions of a recession, economic growth is forecast in the United States.
To further test the forecasting technique, the IRRA for South Korea was also calculated using stock index options. South Korea trades on the KOSPI 200 Index, the world’s most liquid stock index options. Like the United States, South Korea is predicted to continue to enjoy economic growth.
The economic forecast for the United Kingdom, Germany and Japan were less certain using IRRA. According to the researchers, these financial markets had less liquid stock index options, and therefore the option trading volume was less compared to the US and South Korea. Option prices were therefore less informative for future economic conditions.
George Skiadopoulos, Professor of Finance at Queen Mary’s School of Economics and Finance, was one of the lead authors of the paper. Professor Skiadopoulos explained: “Examining all five countries sheds light on the properties of the option-based variable as a predictor. We used a dataset that included events of great economic turbulence, which made it more challenging to predict economic growth, so the chosen sample is a high hurdle for the proposed predictor to pass.”
The researchers argue that IRRA should be included in the list of predictor variables of economic growth for at least the US and South Korea.
George Skiadopoulos is Professor of Finance at Queen Mary University of London and the University of Piraeus, Greece. Other authors of the study include Renato Faccini (Queen Mary University of London), Eirini Konstantinidi (Alliance Manchester Business School) and Sylvanna Sarantopoulou-Chiourea (Independent Authority for Public Revenue).
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